3 April 1998 External T.I. 9720515 - ITAR 26(5)

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: Itar 26(5) does not apply to shares received in exchange.

Position:wording of provision.

Reasons:

XXXXXXXXXX 							5-970251
D. Yuen

Attention:  XXXXXXXXXX 

April 3, 1998

Dear Sirs:

Re: Subsection 84.1(2) of the Income Tax Act¹

We are writing in response to your letter of January 28, 1997 wherein you requested interpretations on the calculation of the adjusted cost base of shares in the following situation.

Situation

(a) X Co existed prior to 1972 and was owned by taxpayer A and his brother, D, and their spouses.

(b) On January 3, 1972 A transferred a portion of his holdings to his two sons, B and C. Since this transaction occurred immediately after Valuation Day, it is assumed that no capital gain was reported as a result of the transfers.

(c) As a result of a divorce settlement, A received the X Co shares owned by his spouse in 1980. This transaction was recorded at the adjusted cost base of the shares being the Valuation Day value.

(d) In 1986, A acquired the X Co shares owned by B for their fair market value at that time. It is assumed that B claimed a capital gain deduction pursuant to section 110.6.

(e) In 1987, the assets of X Co were divided between A and his family and D and his family in a "butterfly" reorganization. A and C exchanged their shares of X Co for shares of Y Co. A and C each received high-low preferred shares of Y Co (the "Y Co shares") in exchange for their shares of X Co. The Y Co shares had a paid-up capital, within the meaning of subsection 89(1), equal to the original cost of the X Co shares and had a redemption value equal to the fair market value of the X Co shares so exchanged.

(f) A died in April 1993 and pursuant to his Will left all of his Y Co shares to C. The shares were not distributed to C until after the transaction described in paragraph 7. below.

(g) In late 1993, C transferred a portion of his Y Co shares to his spouse, reporting a capital gain and claiming a deduction pursuant to section 110.6. In determining the gain, the adjusted cost base of the Y Co shares to C did not include any of the Y Co shares to be received from A's estate.

(h) C received the Y Co shares from A's estate. Pursuant to subsection 70(9.2), C is deemed to have acquired the shares from A at the time of A's death. A's legal representative elected in respect of the Y Co shares under subsection 70(9.2) at an amount between their adjusted cost base to A and their fair market value. A deduction under section 110.6 was taken for a portion of the gain reported in A's terminal tax return.

Your Questions

(i) With regard to the Y Co shares owned by C, can C consider that he has three lots of shares:

a. Lot 1 - his original holding of X Co shares received from A on January 3, 1972 (exchanged for Y Co shares in 1987) less the shares transferred to his spouse in 1993;

b. Lot 2 - the original shares of X Co owned by A together with the X Co shares acquired from his spouse in 1980 (exchanged for Y Co shares in 1987); and

c. Lot 3 - the shares acquired by A from B in 1986 (exchanged for Y Co shares in 1987).

It is your view that this is acceptable according to Interpretation Bulletin IT-199 ("IT-199").

(j) If C can consider that he has three lots of Y Co shares, can he then allocate the exemption claimed by A under section 110.6 between Lots 2 and 3, as he may wish?

(k) Can C then order, as he may wish, the dispositions of Lots 1 through 3 in determining the adjusted cost base of the Y Co shares for purposes of subsection 84.1(2)?

(l) Is C required to amend his 1993 income tax return regarding the disposition of the Y Co shares to his spouse to average the adjusted cost base of all his Y Co shares he owned and was deemed to own as of the day of the transfer when, in fact, he reported an adjusted cost base consistent with that of Lot 1?

Our Views

The situation described in your letter appears to involve actual completed transactions in respect of a specific taxpayer. Consequently, the taxpayer's local Taxation Services Office is responsible for determining the tax consequences arising from such transactions. However, we can provide the following general comments.

We have assumed that:

(a) the shares of X Co were owned by A, D, and their spouses on June 18, 1971;

(b) no election under subsection 26(7) of the Income Tax Application Rules (the "ITAR") has been filed by A, A's estate or B;

(c) all shares referred to herein are capital property, within the meaning assigned by section 54; and

(d) subsection 73(1) applied to the 1980 transfer of X Co shares to A by his spouse.

(a)

1. IT-199 indicates that identical properties that are shares may be grouped into shares that were acquired before 1972 ("Group 1 shares"), shares that were acquired after 1971 ("Group 2 shares") and shares that are acquired after 1971 and to which subsection 26(5) of the ITAR applies ("Group 3 shares"). As all of the Y Co shares owned by C were acquired after December 31, 1971, there will not be any Group 1 shares. As subsection 26(5) of the ITAR is applicable, as explained below, it is our view that all the Y Co shares of C will be considered Group 3 shares and will be segregated (as indicated in subparagraph 6(a) of IT-199) as follows:

a. Lot 1 will include the Y Co shares which were received in 1987 in exchange for C's original holdings in X Co that were acquired from A on January 3, 1972. Subsection 26(5) of the ITAR will apply in respect of these shares since they were acquired from a non-arm's-length person, A.

b. Lot 2 will include the shares of Y Co which were received by A in 1987 in exchange for A's original holdings in X Co plus the X Co shares which A received from his spouse in 1980 plus the X Co shares that A acquired from B in 1986. Such shares are deemed to have been acquired by C on A's death in 1993 by virtue of subsection 70(9.2). Subsection 26(5) of the ITAR will apply in respect of these shares since they were acquired from a non-arm's-length person, A's estate.

2. Subparagraph 84.1(2)(a.1)(ii), in part, provides that in computing a taxpayer's adjusted cost base (for purposes of section 84.1) of a share acquired by him after 1971 from a person with whom he was not dealing at arm's length, the adjusted cost base otherwise determined is to be reduced by the amount of post-1984 capital gains in respect of prior dispositions of the share or a share for which the share was substituted (or such lesser amount as is established by the taxpayer to be the amount in respect of which a deduction under section 110.6 was claimed) by the taxpayer or a non-arm's-length individual.

While the onus of establishing the "lesser amount ... in respect of which a deduction under section 110.6 was claimed" is on the taxpayer, no procedure is contained in the Act for determining the particular capital gain or gains which represent the deduction claimed under any of subsections 110.6(2), (2.1) or (3). Given that there is no clear prohibition against selecting gains which represent the deduction claimed and no obvious reason that such selection ought not to be available, it is our view that a taxpayer may identify the gains represented by the deduction claimed, even where such identification involves selecting the gains on the disposition of specific properties which are identical to other properties disposed of, but with respect to which no deduction was claimed.

3. As indicated in subparagraph 6(c) of IT-199, C has the option of deciding out of which lot of Y Co shares any transfer of shares may occur. The cost of all the Group 3 shares will be determined by subsection 26(3) and paragraph 26(8)(c) of the ITAR. The adjusted cost base of each of the Lot 1 shares and the Lot 2 shares will be as follows:

a. Lot 1 shares Paragraph 26(5)(a) of the ITAR will apply, for purposes of computing the adjusted cost base to C of the X Co shares, to deem the X Co shares that C acquired from A on January 3, 1972 to be owned by C on June 18, 1971 and thereafter without interruption. Since C acquired the X Co shares from A after 1971, the actual cost to C will be the actual cost to A on January 1, 1972 as provided in paragraph 26(5)(b) of the ITAR and adjusted as required by paragraph 26(5)(c) of the ITAR. It is assumed that the adjusted cost base of the X Co shares became the adjusted cost base of the Y Co shares which were received in 1987 in exchange for C's original holdings in X Co that were acquired from A on January 3, 1972.

b. Lot 2 shares Paragraph 26(5)(a) of the ITAR will apply, for purposes of computing the adjusted cost base to C of the Y Co shares, to deem the Y Co shares that C acquired upon A's death in 1993 to be owned by C on June 18, 1971 and thereafter without interruption. Paragraph 26(5)(b) of the ITAR deems the actual cost to C of those Y Co shares to be the actual cost to A in respect of A's original holdings in X Co, the actual cost to A's spouse in respect of the X Co shares which A received from his spouse in 1980 and the actual cost to B in respect of the X Co shares acquired from B in 1986, adjusted as required by paragraph 26(5)(c) of the ITAR. It is assumed that the adjusted cost base of the X Co shares became the adjusted cost base of the Y Co shares which were received in 1987 in exchange for A's holdings in X Co.

It is noted that the provisions of proposed subsection 84.1(2.01) of Bill C-28 (which received second reading in the House of Commons on February 4, 1998) and subsection 84.1(2.1) may be applicable in the circumstances.

4. Provided all the shares that were disposed of by C to his spouse were Lot 1 shares, there would not appear to be any adjustment to the adjusted cost base used in the calculation of the capital gain required since the adjusted cost base reported would be the same as that determined in respect of the Lot 1 shares, as described above. If the disposition includes Lot 2 shares, an adjustment to the adjusted cost base used in the calculation of the capital gain will be required. If C designates that the disposition consists of Lot 1 shares and Lot 2 shares, the adjusted cost base of those shares would be the total of the proportionate amounts of the adjusted cost base of each of the Lot 1 shares and the Lot 2 shares.

The foregoing comments are given in accordance with the practice referred to in paragraph 22 of Information Circular 70-6R3 dated December 30, 1996 and are not binding on Revenue Canada. The taxpayer's Taxation Services Office would be able to provide more assurance as to the correct treatment of these transactions after a review of all of the taxpayer's particular circumstances.

Yours truly,

for Director
Reorganizations and International Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

¹ All statutory references in this letter are to the Income Tax Act (Canada), R.S.C. 1985 (5th Supp.) c. 1, as amended (the "Act").

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